How China is keeping U.S. bond yields low

SaumyaVaishampayan

BenEisen

NEW YORK (MarketWatch) — China’s efforts to weaken its currency could be bolstering U.S. Treasurys and weighing on a rally in the dollar against the euro.

The Asian nation’s currency actions, thought to be an effort to boost its slowing economy, have contributed to these unlikely trading patterns, market participants say. It’s the latest way in which China’s economy has become intertwined with the U.S., five years after an American real estate bust elicited finger-pointing at the role Chinese funds played in cheap U.S. mortgages.

The 10-year Treasury
US:10_YEAR
yield fell from over 3% at the start of the year to an 11-month low of 2.44% at the end of the May; it more recently traded at 2.60%. The push lower in yields came even amid signs that the U.S. labor market recovery is picking up. All things being equal, yields were primed to rise.

The dollar
EURUSD, +0.1054%
has similarly moved at cross-purposes to what’s expected as the economy strengthens and the Federal Reserve starts to tighten monetary policy. The dollar fell 0.2% against the euro in the first quarter, even as declining euro-zone inflation made it more likely that the European Central Bank would have to ease further. The dollar is up 1.5% against the euro this year, a modest bump compared to expectations.

As U.S. Treasury yields have fallen this year, companies and consumers have found it less expensive to borrow money. Simultaneously, the lack of a major dollar rally against the euro means that U.S. exports are more competitive than they were expected to be.

Among the variety of explanations, demand from China continues to grab the attention of traders and strategists. It starts with the depreciation of the Chinese yuan
USDCNY, -0.1373%
against the dollar in 2014. Some attributed the move to the government’s desire to shake out speculators betting on a continued rise in the Chinese currency, while others point to the fact that a weaker currency makes Chinese exports more attractive. Whatever the reason, the dollar rose 2.7% against the yuan in the first quarter of 2014, marking the first quarterly gain since the three months ended June 2012, according to FactSet data.

To accomplish that depreciation, China has sold yuan and bought dollars, leaving it with a huge pile of American currency in its reserve. In the first quarter, China’s official data show its foreign-exchange reserves rose by $129 billion to $3.95 trillion, touching an all-time high.

By most accounts, China likely doesn’t want to keep its increased stash of greenbacks. Traders and market participants on the front lines speculate that the U.S. dollars have been used to buy U.S. Treasurys and have been swapped for euros, adding to demand in those markets.

“You can be reasonably comfortable saying they buy a lot of Treasurys, diversify a lot into euros,” said Steven Englander, head of G10 foreign-exchange strategy at Citi, referring to the Chinese.

Of course, it’s difficult to attach changes in China’s reserves to any specific market movements because the data is lagged. But when markets act up, the “China explanation” tends to lurk.

“The Chinese economy and Chinese demand for U.S. Treasurys is significant in the big picture,” said Gregory Whiteley, government bond portfolio manager at DoubleLine Capital LP.

But there are also skeptics who argue that the influence of China is too readily given.

“Generally, you talk about China when you don’t know what’s happening,” said Sebastien Galy, senior foreign-exchange strategist at Societe Generale. “It’s a nice story and completely unverifiable,” he said.

The Belgium gambit

One way to gauge flows is by looking at Treasury International Capital data, which break down U.S. government debt holdings by country each month. But the data is released with a two-month lag, and can include securities in one country that are actually being held in custody for another country, called a custodian bias.

China’s official holdings of Treasurys moderated in March, but at the same time, Belgium’s holdings have surged, making the tiny European country the third largest holder of U.S. debt, according to Treasury International Capital data from March that was released in May, the latest available. The combined rise of U.S. debt held by China and Belgium tracks the growth in foreign exchange reserves, according to data from Wrightson ICAP LLC. That suggests China may be buying Treasurys under the guise of a different nationality.

Euroclear, a Belgium-based securities depository and custody provider, is often cited as a potential channel through which Treasurys are bought.

“You can make a circumstantial case that the fact that China’s reported holdings leveled off about the time Belgium’s holdings were exploding, and the fact that China was expanding reserves makes that a possibility,” said Lou Crandall, chief economist at Wrightson ICAP LLC. But Crandall emphasizes that while these flows are all possible, the lack of data makes it difficult to confirm.

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